RFXplainer: Foreign exchange contracts explained

Whether you’re purchasing property abroad or just looking to go on holiday with as much money as possible, foreign exchange can be a complicated thing to get your head around. It can often feel like unless you have an intimate knowledge of the foreign exchange market, you basically get what you’re given. If your currency is having a good day, great. If it’s not, bad luck.

But that’s just not true. 

Most foreign exchange providers, especially those who deal with larger sums or international transfers, will offer a range of foreign exchange contract options. These contracts – sometimes known as trades – can help you take advantage of market highs and protect you from the lows. 

There are four main foreign exchange contracts. These are: 

  • Spot contract
  • Limit order
  • Stop loss
  • Forward contract

Here we’re going to go through them and explain how they work and what they’re best used for.

You’re unlikely to get these sorts of contracts at your local bureau de change or online travel money provider and will need to speak to a foreign exchange specialist. If you’d like one of the RationalFX currency experts to give you a call to discuss how any of the options below can help you, all the information you need is here.

Spot contract

How it works

A spot contract is your standard foreign exchange contract. When you go to the post office or bureau de change or use a travel money site or app, you’re doing a spot contract. It means that right then – ‘on the spot’ – you purchase money in another currency at the rate you’re offered. 

This rate will be close to the day’s ‘mid-market’ rate, also known as the ‘true’, ‘interbank’ or ‘spot’ rate. This is the rate you’ll see on sites like XE.com or if you Google a currency pair (such as GBP/EUR). It’s the theoretical mid-point between buyers and sellers of a currency. However, no one is able to get this rate and depending which foreign exchange provider you go with will depend on how close you get to that rate. Some will offer you the mid-market rate and add commission or fees on top while others will offer ‘no commission’ and instead offer you a rate that involves a ‘spread’. A ‘spread’ is the difference between the rate the initial buyer of the currency (like a foreign exchange provider) gets and the rate they offer to their buyer. 

What can a spot contract be used for?

A spot contract is best used when a rate is doing particularly well. For example, if you hear in the news that the GBP/USD or EUR/JPY is at month or year high, it’s a good time to contact a foreign exchange provider. 

It’s also good for smaller trades like holiday money. Although a great exchange rate can certainly help you get more bang for your holiday buck, the losses and gains will often be marginal. Your choice of holiday money provider and the fees, commission or spread they apply will have a much bigger impact. 

Limit order

How it works

A limit order lets you set a target exchange rate for the future and if that rate is reached, your broker or foreign exchange provider will purchase your currency for you. It means if the currency pair you’re interested in isn’t doing too well and you can afford to wait, you can still try and get a rate you’re happy with. 

Often they are used in conjunction with a stop loss order. We’ll go into more about these contracts next but they’re basically the opposite of a limit order. Instead of setting a target rate you set the lowest rate you’d be comfortable trading at. They are designed to protect you from further losses if your currency pair drops. 

When this is done, an OCO order is normally set up too. This stands for ‘one-cancels-the-other’ or ‘order cancel order’ and means you can book in two types of contracts which have conflicting aims. So your limit order contract being triggered will cancel your stop loss contract and vice versa. 

What can a limit order be used for?

Limit orders can be very beneficial for those with regular payments abroad like a payroll or tuition fees. However, they will often come as part of a wider currency strategy involving the other contracts mentioned here. By using a limit order for regular payments, you can set yourself up to take advantage of any market moves in your favour. 

This case study on how we helped a manufacturing firm explains just how that can work. 

Depending on what you need your currency for, a limit order is also a good way to try and profit from big moves in the foreign exchange market as it gives you room to be particularly speculative and ambitious.   

For example, if you don’t immediately need the currency because you’re not planning to make the payment on a property you’re purchasing or if you pay international staff an annual bonus. 

It can, of course, also be very useful to FX traders looking to profit off the market and those selling currency often also set a limit order to sell at a target rate. 

If you’re not an FX trader, however,  it can be difficult to know what a realistic target rate might be and is worth consulting with a currency specialist before setting up a limit order. 

Stop loss

How it works

A stop loss does exactly what the name suggests. It stops losses. Or stops you losing more than you’re comfortable with anyway. 

It works just like a limit order but it’s designed to protect you against negative market fluctuations instead of profiting from positive ones. 

You set the lowest rate you’d be comfortable trading at and if it  drops to that, your foreign exchange provider will automatically purchase the currency you’re interested in on your behalf. 

As we’ve said above, stop loss contracts are usually set up alongside a limit order and are further backed up by an OCO order. 

What can a stop loss be used for?

A stop loss is often used for similar reasons to a limit order. If you’re required to make regular international payments or to receive them – like a pension if you’ve retired abroad – they can be a good way to protect you against any significant drops in the market. 

Obviously the priority with foreigh exchange is always to take advantage of strong rates, which is why when used in this way, they often form part of a wider strategy.  This case study on how we helped a manufacturing firm shows how a stop loss can work in conjunction with a forward contract and limit order. 

If you’re looking to try and take advantage of market moves either for a future payment or as a trader, they’re a vitally important tool to stop you making any significant losses.

Forward contract 

How it works

A forward contract or forward trade is a great way to secure a rate for a set amount of time. If, for example, GBP/EUR hits a monthly or year high you would contact your foreign exchange provider or broker and they would lock that rate in for a designated period. This is at the discretion of your provider. At RationalFX, we normally set it at two years. 

This means that at any point over that period you can purchase currency at that rate. Depending on the details of the contract, this can be for one transaction or a series of transactions. 

Forward contracts are generally secured with a deposit, also known as a margin. This tends to be a percentage of the value of the trade. Other factors can often have an impact like the currencies involved and the length of the contract. 

What can a forward contract be used for?

Forward contracts are especially useful if you’re making a large purchase but don’t need to make the payment immediately. For example, when purchasing property abroad you may know how much you need to transfer but not need to do it right away. And if there’s a particularly strong rate, you’ll want to secure that for the payment date. 

When forward contracts are used for big purchases they can end up saving you thousands of pounds. Read this case study on how we helped a client buy a home abroad and do just that.

They’re also great if you have regular international payments as you’re able to guarantee a great rate for every invoice, payroll or tuition payment over a set period of time. 

If you’d like to know more about how these foreign exchange contracts or a strategy combining them can help you, get in touch with one of our currency specialists. 

Your dedicated currency specialist will work with you to build a strategy suited to your needs. They’ll help you lock in exchange rates, mitigate against market risks and deal with the red tape required for international payments.